The Measurement and Structure of the National Economy

1. The Measurement and Structure of the National Economy ECON 202 – Fall 2012

2. Chapter Outline • Microeconomics vs. Macroeconomics • National Income Accounting: The Measurement of Production, Income, and Expenditure • Gross Domestic Product • Real GDP, Price Indexes, and Inflation

3. Microeconomics vs. Macro • Microeconomics focuses on how decisions are made by individuals and firms and the consequences of those decisions. • Macroeconomics, in contrast, examines the aggregate behavior of the economy – how the actions of all the individuals and firms in the economy interact to produce a particular economy-wide level of economic performance.

4. Microeconomics vs. Macro

5. Microeconomics vs. Macro • A key insight into macroeconomics is that in the short run – a time period consisting of several years but typically less than a decade – the combined effect of individual decisions can have effects that are very different from what any one individual intended, effects that are sometimes perverse. The behavior of the macroeconomy is greater than the sum of individual actions and market outcomes. • Non-econ example: “rubber-necking”. • Macro example: the “Paradox of Thrift”

6. Microeconomics vs. Macro • Careful study of how markets work has led microeconomists to the conclusion that government should typically leave markets alone. Except in certain well-defined cases, government intervention in markets usually leaves society as a whole worse off. • In contrast, economists generally believe there is a much wider role for government to play in macroeconomics – most importantly, to manage short-term fluctuations and adverse events in the economy. • The origins of this view that the government should take an active role in the management of the macroeconomy lie in the Great Depression of the 1930s. • The modern macroeconomic toolkit consists of fiscalpolicy, control of government spending and taxation, and monetary policy, control over interest rates and the quantity of money in circulation.

7. Microeconomics vs. Macro • Microeconomics focuses on problems that take the amount of output the economy is capable of producing as given. • Macroeconomics examines the longer-run problem of how a society can increase the total amount of productive resources so that it can achieve higher rates of growth and a higher standard of living. Moreover, what governments should or shouldn’t do to promote long-run growth is also an important area of study.

8. Microeconomics vs. Macro • A distinctive feature of modern macroeconomics is that both its theory and policy implementation focus on economic aggregates – economic measures that summarize data across many different markets for goods, services, workers, and assets.

9. National Income Accounting • National income and product accounts: an accounting framework used in measuring current economic activity • In the U.S., calculated by the Bureau of Economic Analysis, a division of the Commerce Department • Keep track of the spending of consumers, sales of producers, business investment spending, government purchases, and a variety of other flows of money between different sectors of the economy.

10. National Income Accounting • To judge whether or not an economy is doing well, it is useful to look at Gross Domestic Product (GDP) • Three alternative approaches give the same measurements • Product approach: the amount of output produced • Income approach: the incomes generated by production • Expenditure approach: the amount of spending by purchasers • Juice business example shows that all three approaches are equal

11. National Income Accounting • Why are the three approaches equivalent? • They must be, by definition • Any output produced (product approach) is purchased by someone (expenditure approach) and results in income to someone (income approach) • Production generates income, which in turn results in the purchasing power that generates the demand for products. If I pay you $100 to prune my apple trees, the expenditure on the orchard service ($100) is exactly equal to the income earned from the production of the garden service ($100). • You can see this from the circular flow diagram. • The fundamental identity of national income accounting: total production = total income = total expenditure

12. Gross Domestic Product • The product approach to measuring GDP • GDP (gross domestic product) is the market value of all final goods and services produced within a country in a given period of time

13. Gross Domestic Product • “GDP is the market value…” • Allows adding together unlike items by valuing them at their market prices • Government services (that aren’t sold in markets) are valued at their cost of production

14. Gross Domestic Product • Example: The country of Ellensburgistan produces two goods: footballs and basketballs. Below is a table showing prices and quantities of output for three years: • Nominal GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600 • Nominal GDP in Year 2 = ($12 × 200) + ($15 × 300) = $6,900 • Nominal GDP in Year 3 = ($14 × 180) + ($18 × 275) = $7,470

15. Gross Domestic Product • “…of All…” • GDP includes all items produced and sold legally in the economy. • There is some adjustment to reflect the underground economy • The value of housing services is somewhat difficult to measure. • If housing is rented, the value of the rent is used to measure the value of the housing services. • For housing that is owned (or mortgaged), the government estimates the rental value and uses this figure to value the housing services.

16. Gross Domestic Product • “…Final…” • Don’t count intermediate goods and services (those used up in the production of other goods and services in the same period that they themselves were produced) • Final goods & services are those that are not intermediate • Capital goods (goods used to produce other goods) are final goods since they aren’t used up in the same period that they are produced

17. Gross Domestic Product • “…Final…” • Inventory investment (the amount that inventories of unsold finished goods, goods in process, and raw materials have changed during the period) is also treated as a final good • Goods that are sold out of inventory are counted as a decrease in inventory investment. • The goal is to count the production when the good is finished, which is not necessarily the same time that the product is sold. • Adding up value added works well, since it automatically excludes intermediate goods

18. Gross Domestic Product • “…Goods and Services…” • GDP includes both tangible goods and intangible services.

19. Gross Domestic Product • “…Produced…” • As mentioned above, only current production is counted • Used goods that are sold do not count as part of GDP

20. Gross Domestic Product • “…Within a Country…” • GDP measures the production that takes place within the geographical boundaries of a particular country. • If a Canadian citizen works temporarily in the U.S., the value of his output is included in GDP for the U.S. If an American owns a firm in Nicaragua, the value of the production of that firm is not included in U.S. GDP.

21. Gross Domestic Product • “…in a Given Period of Time.” • The usual interval of time used to measure GDP is a quarter (three months). • When the government reports GDP growth, the data is generally reported on an annual basis. • In addition, data are generally adjusted for regular seasonal changes (such as Christmas).

22. Gross Domestic Product • The expenditure approach to measuring GDP • Measures total spending on final goods and services produced within a nation during a specified period of time • Four main categories of spending: consumption (C), investment (I), government purchases of goods and services (G), and net exports (NX) • Y = C + I + G + NX • the income-expenditure identity

23. Gross Domestic Product • The expenditure approach to measuring GDP • Consumption: spending by domestic households on final goods and services (including those produced abroad) • About 2/3 of U.S. GDP • Three categories • Consumer durables (examples: cars, TV sets, furniture, major appliances) • Nondurable goods (examples: food, clothing, fuel) • Services (examples: education, health care, financial services, transportation)

24. Gross Domestic Product • The expenditure approach to measuring GDP • Investment: spending for new capital goods (fixed investment) plus inventory investment • Not to be confused with purchases of stocks, bonds, etc. – these are purchases of financial instruments, and are simply exchanges of money… not associated with production of output • About 1/6 of U.S. GDP • Business (or nonresidential) fixed investment: spending by businesses on structures and equipment and software • Residential fixed investment: spending on the construction of houses and apartment buildings • Inventory investment: increases in firms’ inventory holdings

25. Gross Domestic Product • The expenditure approach to measuring GDP • Government purchases of goods and services: spending by the government on goods or services • About 1/5 of U.S. GDP • Most by state and local governments, not federal government • Not all government expenditures are purchases of goods and services • Some are payments that are not made in exchange for current goods and services • One type is transfers, including Social Security payments, welfare, and unemployment benefits • Another type is interest payments on the government debt • Some government spending is for capital goods that add to the nation’s capital stock, such as highways, airports, bridges, and water and sewer systems

26. Gross Domestic Product • The expenditure approach to measuring GDP • Net exports: exports minus imports • Exports: goods produced in the country that are purchased by foreigners • Imports: goods produced abroad that are purchased by residents in the country • Imports are subtracted from GDP, as they represent goods produced abroad, and were included in consumption, investment, and government purchases

27. Expenditure Approach to Measuring GDP in the United States, 2011:2

28. Gross Domestic Product • GNP vs. GDP • GNP (gross national product) = output produced by domestically owned factors of production • GDP = output produced within a nation • GDP = GNP – NFP • NFP = net factor payments from abroad = payments to domestically owned factors located abroad minus payments to foreign factors located domestically

29. Gross Domestic Product • GNP vs. GDP • Example: Engineering revenues for a road built by a U.S. company in Saudi Arabia is part of U.S. GNP (built by a U.S. factor of production), not U.S. GDP, and is part of Saudi GDP (built in Saudi Arabia), not Saudi GNP • Difference between GNP and GDP is small for the United States, about 0.2%, but higher for countries that have many citizens working abroad

30. Gross Domestic Product • The income approach to measuring GDP • Adds up income generated by production (including profits and taxes paid to the government) • National income = compensation of employees (including benefits) + proprietors’ income + rental income of persons + corporate profits + net interest + taxes on production and imports + business current transfer payments + current surplus of government enterprises • National income + statistical discrepancy = net national product • Net national product + depreciation (the value of capital that wears out in the period) = gross national product (GNP) • GNP – net factor payments (NFP) = GDP

31. Gross Domestic Product • The income approach to measuring GDP • Private sector and government sector income • Private disposable income = income of the private sector = private sector income earned at home (Y or GDP) and abroad (NFP) + payments from the government sector (transfers, TR, and interest on government debt, INT) – taxes paid to government (T) = Y + NFP + TR + INT – T • Government’s net income = taxes – transfers – interest payments = T – TR – INT • Private disposable income + government’s net income = GDP + NFP = GNP

32. Income Approach to Measuring GDP in the United States, 2005

33. Real GDP, Price Indexes, and Inflation • Real GDP • Nominal variables are those in dollar terms • Problem: Do changes in nominal values reflect changes in prices or quantities? • Real variables: adjust for price changes; reflect only quantity changes

34. Production and Price Data

35. Real GDP, Price Indexes, and Inflation • Real GDP • Nominal GDP is the dollar value of an economy’s final output measured at current market prices • Real GDP is an estimate of the value of an economy’s final output, adjusting for changes in the overall price level • We are going to use real GDP as a proxy for aggregate production throughout the course.

36. Calculation of Real Output with Alternative Base Years

37. Real GDP, Price Indexes, and Inflation • Price Indexes • A price index measures the average level of prices for some specified set of goods and services, relative to the prices in a specified base year • GDP deflator = 100  nominal GDP/real GDP • Note that base year GDP deflator = 100

38. Real GDP, Price Indexes, and Inflation • Price Indexes • Choice of expenditure base period matters for GDP when prices and quantities of a good, such as computers, are changing rapidly • BEA compromised by developing chain-weighted GDP • Now, however, components of real GDP don’t add up to real GDP, but discrepancy is usually small

39. Real GDP, Price Indexes, and Inflation • Price Indexes • Inflation • Calculate inflation rate: t+1= (Pt+1 – Pt)/Pt = Pt+1/Pt • Following Figure shows the quarterly U.S. inflation rate since 1989 for the GDP deflator

40. The Inflation Rate in the United States, 1960-2005

41. Is GDP a Good Measure of Economic Well-Being? • GDP per capita (i.e., GDP per person) tells us the income and expenditure level of the average person in the economy • GDP, however, may not be a very good measure of the economic well-being of an individual. • Omits important factors in the quality of life including leisure, the quality of the environment, and the value of goods produced but not sold in formal markets • Says nothing about the distribution of income • GDP tends to measure disasters and other waste as gains • However, a higher GDP does help us achieve a good life. Nations with larger GDP generally have better education and better health care, among other things.